Global Tax Insights
Is Your Business eligible to Claim an R&D Tax Credit?December 06, 2013
Claiming your research and development tax credits may be easier than you think.
* Revised 3/11/2016
The research and development tax credit has helped companies explore innovations for new and existing products since its inception in 1981. The credit has finally been made a permanent part of Federal tax law. This will allow business owners to plan their current and future R&D activities with some certainly. Despite the credit’s firm standing as one of the most lucrative tax benefits a business may qualify for, the language surrounding eligibility and confusion over what constitutes as “research and development” can be intimidating, and discourage many eligible businesses from rightfully claiming the benefit.
The R&D credit can be both a federal and state credit. State credits vary on a state-by-state basis. Eligible companies may be in a position to reduce their corporate income taxes by up to 20% of their qualified research expenditure. Owners of flow through entities (e.g.., S-Corporations, LLCs etc.) can use the credit on their individual tax returns to reduce their taxes. The credit is not limited to specific industries. This is a common misconception. Many business sectors may qualify for the benefit, including, but certainly not limited to: aerospace, electronics, food and drugs, software design, cosmetic development etc.
Definition of ‘Research’
The Internal Revenue Service defines qualified research as meeting the conditions of four tests, outlined below.
1. Permitted purpose. This part of the test ensures that the activity must intend to develop a new or improved product, process or procedure. It requires that research be conducted with the intention of improving on establishing new business components in at least one of the following areas:
2. Technological Scope. The research being conducted must also rely upon one of the four science principles listed below:
3. Elimination of uncertainty. This simply states that the intent of the research must be related to discovering information to eliminate uncertainty or introduce new methods or processes that could improve a product or the process by which a product is made.
4. Experimentation. In short, a series of experiments must be carried out during the research process that include the core elements of the process of experimentation. The experimentation must identify the uncertainty, identify one or more alternatives and identify and conduct a process of evaluating the alternatives.
Several activities may fall into the scope of these four rules, such as developing prototypes or models, applying for patents, certification testing, streamlining internal processes, conducting environmental testing and developing new business or software technologies.
Types of Qualifying Expenditures
Companies whose activities meet the definition of research and development may be permitted to deduct qualifying R&D expenditures. The IRS considers these expenditures to be “reasonable costs you incur in your trade or business for activities intended to provide information to help eliminate uncertainty about the development or improvement of a product.”
For the purposes of the credit, there is also a flexible and somewhat broad classification of “product”. A product is considered a formula, invention, patent, pilot model, process, technique or similar property.
When it comes to claiming the credit, R&D must directly relate to improving or establishing a product. For instance, companies developing a patent may be permitted to deduct attorney’s fees. However, some expenditures that are seemingly associated with R&D are not allowable. These include:
- Quality control testing
- Advertising or promotions
- Consumer surveys
- Efficiency surveys
- Management studies
- Research in connection with literary, historical, or similar projects
- The acquisition of another’s patent, model, production or process
Don’t Lose the Credit
Businesses may face a limited timeline in which they can generate and claim the credit, making it important for companies implementing new projects to work with tax and engineering professionals to determine eligibility and get the maximum benefit allowed from their R&D expenditures.
Additionally, in order to claim the credit, businesses must have or develop proper documentation and records. Because the federal and state governments dole out millions in R&D incentives each year, they require qualifying R&D activities to be supported by proper documentation. Companies seeking to prove that they qualify will need to have records such as time tracking, project accounting, test results etc. Most businesses that don't currently keep track of this information have the information required to compile these documents without realizing it. Once completed it is generally easy to put a tracking and record keeping system in place that will comply with the requirements thus avoiding having to create the documentation after that fact. Although as mentioned above, the subsequent compilation of the information is allowed.
For more information or help compiling your R&D qualification paperwork please contact Robert D’Andrea, CPA or any member of our team at 888-KLR-8557.